Submitted by Edward Harrison of the site Credit Writedowns
The first bank nationalization in German history is about to take place. At issue is Hypo Real Estate (HRE), a troubled Munich-based company that lends to commercial property developers and to build offices, hotels, roads, airports, you name it.
This issue has been building for nearly 7 months. Back in late September, just after Lehman went under, the Germany government was forced to bail HRE out as it ran into funding problems at its Irish subsidiary, Depfa. Since then, the situation at HRE has gotten considerably worse. Cognizant that it had a Lehman situation on its hands, the German government went so far as to change the laws to allow it to nationalize HRE. This is about to happen.
The Financial Times writes:
The government has given HRE shareholders until May 4 to accept the offer. As of Thursday more than 7.5 per cent of HRE shares had been tendered, giving the government control of 16.2 per cent of the company. It already held a stake of more than 8.6 per cent after a small capital increase last month.
At the end of the offer period the government hopes it will control enough HRE votes to force through a much larger capital increase at a shareholder meeting. It could eventually use “squeeze-out” rules to force out JC Flowers and other remaining minority shareholders.
If this does not work – as it may not, if enough shareholders reject the tender offer – a recently passed law will allow expropriation of HRE shares. It would be the first nationalisation of a German bank since the 1930s.
Expropriation would be compensated but the government has warned this is likely to be at a lower price than that proposed in the tender offer.
The US firm hinted at a legal challenge to try to stave off expropriation, pointing to expert opinions that “indicated considerable reservations” about the expropriation law and another piece of legislation approved last month. “JC Flowers is reviewing, in the interest of its investors, all options,” the firm said.
Some JC Flowers investors, holding less than 1 per cent of HRE shares, will accept the government’s offer.
I have written a number of posts about the situation at HRE:
- European banking collapse including nationalisation of three banks – 29 Sep 2008
- Germany: banking system collapse possible due to Hypo Real Estate – 4 Oct 2008
- The Germans guarantee all savings deposits – 5 Oct 2008
- The German $400 billion toxic asset time bomb – 17 Jan 2009
- Hypo Real Estate: 600 billion in off-balance sheet assets – 20 Feb 2009
- More problems at three European financial institutions – 29 Mar 2009
- German banks loaded with 816 billion in toxic paper – 26 Apr 2009
I have been following this story closely because I used to work for the predecessor bank of HRE. In the mid-1990s, I worked at a consulting company in Munich under the now head of HVB Group in a project to re-engineer HRE predecessor Bayerische Vereinsbank’s credit processes. My boss, an extremely decent man, later moved on to Goldman Sachs and then over to HVB as their CEO.
I mention this because I see HRE’s problems as linked to its predecessor organizations and the culture of risk that developed after the Berlin Wall fell. Obviously, this is just my view given that I in no way have worked for HRE.
Here’s my understanding of the matter. Bayerische Vereinsbank and Bayerische Hypothekenbank both ran into trouble due to ‘Verspekulierungen (bad speculation)’ in the period immediately after German re-unification. Vereinsbank and Hypobank were front and center in the speculative property bubble that developed in the former East Germany after the Wall fell. This was one reason my consulting firm was working at Vereinsbank.
In 1996, Hypobank revealed huge losses in eastern Germany even though the Board of Directors had been aware of the problem since early 1994 (does this sound familiar). In fact, fraud was a factor at Hypobank.
Vereinsbank had their own problems. So, subsequently, in 1998, those two organizations came together as Hypo Vereinsbank (later HVB Group) in a merger of necessity despite being bitter crosstown rivals. They are the largest banks in Bavaria with a long crosstown rivalry and history dating back to 1780 at Hypobank and 1869 at Vereinsbank. The deal was touted as a Munich counterweight to the big three German banks Deutsche Bank, Dresdner Bank and Commerzbank, all based in Frankfurt.
Unfortunately, they were forced to write off 3.5 billion that same year because of Hypo’s eastern German speculation. (Later in 2005, 7 years later, bad bets on the Vereinsbank side were uncovered as well costing the bank 2.5 billion).
Fast forward to 2003 and HVB spins off HRE before HVB itself gets taken over by Unicredito two years later. Now, I haven’t been integrally involved with HVB or HRE since, but again the history of risk taking is there. And I should mention that HVB and Unicredito are problem children with huge exposure to Eastern Europe.
By 2007, HRE was a force to be reckoned with and they looked to increase in size. They bought Depfa at the top of the market in a deal not unlike the Golden West Financial deal that Wachovia did in 2006.
Now Depfa, which caused HRE’s near collapse in October, is not an Irish company at all. It is in Ireland merely as a tax dodge (another example of how the Irish are massively and unwisely leveraged to the financial services industry). In reality, Depfa is a German institution, the Deutsche Pfandbrief Bank. (As an aside, back in 2008, Hank Paulson talked a lot about Pfandbriefs as a panacea for the U.S. mortgage market. I have two posts on that from last summer here and here).
So Depfa was lending long and borrowing short. When Lehman collapsed it ran into liquidity problems, so a consortium of German bank creditors struck a deal to bail out HRE and its subsidiary. But, this deal collapsed and the German government was forced to step in.
In reality, HRE was a ticking time bomb and this is the reason it had run into liquidity problems (By the way, this is much the way I see Northern Rock – which was also nationalized by the UK government). The company has massive commercial property (CRE) exposure and the CRE market is imploding in financial centers like Frankfurt, London and Dublin and elsewhere. HRE is highly leveraged to these places.
HRE is also systemically important because it has a huge loan book in commercial property in Germany, Ireland and in Europe more generally. It also has a lot of off-balance sheet exposure a la Citigroup. Its failure would cause great distress to the market it operates in.
Moreover, it has counterparties and lenders. So, its demise would adversely impact those institutions. I don’t have a list of those lenders in front of me but the consortium banks which failed to bail it out in October are the biggest ones. I’m sure it’s a list of who’s who in German finance.
What has the press left out in all of this? Dunno. I would say the bailout is similar to what we are seeing with systemically important institutions in every single Western country (Fortis in the Benelux, RBS in the UK, Citigroup in the US). In short, a property bubble and massive bust has meant that the most imprudent lenders now face ruin. Unfortunately, the web of actors in our financial system is so intricate and the imprudent lenders so large that governments are loathe to allow them to simply collapse. The demise of Lehman Brothers has sent a signal that this raises a very real spectre of Financial Armageddon.
Come May 5th, a large part of this problem will be solved for the Germans. The only German non-state bank left with massive exposure is Commerzbank, and its day is coming too.
UPDATE 930ET: A comment below makes it clear that one could mistake this post for a ‘Gloom and Doom’ piece. It is not. The essence of what I am saying is this:
HRE is a systemically-important institution that has a lot of credit losses due to loose lending standards (or liquidity constraints if you believe it is liquidity and not solvency). As a result, the Government has bailed it out, and will nationalize it soon.
This is a net plus for Germany because it defuses the potential for systemic risk (you should clearly see this as a veiled statement regarding the American desire to NOT do the same).
The only other bank of systemic importance with lots of credit exposure is Commerzbank. And I am sure it will be taken care of in due course (either nationalized or bailed out with more funds).
The upshot of all of this is:
1. Nationalization is an option that can have a positive effect
2. The credit problems at many institutions is a result of loose lending NOT a systemic problem. Deutsche Bank has much less risk on their balance sheet, for example.
3. This, therefore points out the need for increased oversight of the financial sector as a policy remedy.
Sources
JC Flowers rejects Berlin’s offer for HRE – FT.com
HRE: Die erste Enteignung in Deutschland – Handelsblatt
HypoVereinsbank – Wikipedia (German)
HypoVereinsbank – Gourt (German)
Depfa Bank – Wikipedia (German)
8 comments
Comments are closed.
Oooo. This could be nasty.
as far as i remember from the september going-ons, the problem before HRE was its inability to tap the commercial paper markets to continuously fund its long term loans. and they had some problems at Depfa (real estate), but all government guarantees are on german paper used to fund primarily government projects. for that reason, the government is stepping in and attempting to seize the bank: it is a conduit for public projects.
can you offer some numbers besides the gloom and doom and end of the world edward? this is the second quite unsbstantiated article you publish on german banking: the other about 816bn euro problem loans that in your literal translation seemed like total loans of that amount, some of which might be problematic. i personally do not see the german government defaulting on its loans, since it is among the most fiscally restrained in the world. any substance besides the sensationalism would be much appreciated, there are other venues for hog wash like the telegraph and lately the wsj.
bb,
I never implied the German government is going to default. Nor is this a gloom and doom piece. I see the nationalization of HRE as a positive event. The essence of what I am saying is this:
HRE is a systemically-important institution that has a lot of credit losses due to loose lending standards (or liquidity constraints if you believe it is liquidity and not solvency). As a result, the Government has bailed it out, and will nationalize it soon.
This is a net plus for Germany because it defuses the potential for systemic risk (you should clearly see this as a veiled statement regarding the American desire to NOT do the same).
The only other bank of systemic importance with lots of credit exposure is Commerzbank. And I am sure it will be taken care of in due course (either nationalized or bailed out with more funds).
The upshot of all of this is:
1. Nationalization is an option that can have a positive effect
2. The credit problems at many institutions is a result of loose lending NOT a systemic problem. Deutsche Bank has much less risk on their balance sheet, for example.
3. This, therefore points out the need for increased oversight of the financial sector as a policy remedy.
bb,
One last comment on that score comes from a USA today article that echoes my sentiments from this post about poor lending, nationalization, and bailouts:
http://www.usatoday.com/money/economy/2009-04-29-swedish-bank-expert-us-efforts_N.htm?csp=34
“U.S. officials should confront the financial industry’s political power and seize temporary ownership of troubled banks, Borg says. Otherwise, error-prone bankers will be bailed out at taxpayer expense. “We can’t let them get away with the fact that they’ve been reckless,” Borg told a group of economists while attending the recent International Monetary Fund and World Bank meetings here.”
As for the previous article, I made some relevant comments on Seeking Alpha that read:
First, Germany never participated in the bubble, yet the German banks did through their investments in U.S., Eastern European, Irish or Spanish securities markets. Depfa and the Land Banks come to mind here.
However, it should also be noted that we are probably talking about nominal dollars of assets at book value here. These numbers being bandied about in no way reflect the magnitude of eventual writedowns that will be taken – this is probably an order of magnitude less.”
The German banks are in worse financial shape than we have been led to believe. However, the caveat in my second point would suggest it is not nearly as big as 800 billion euros.
Depfa was not the only financial entity operating out of Ireland and many of the financial institutions which operated from their read like a who is who of firms in trouble. Northern Rock like Bradford and Bingley were trying to complete with the likes of depfa and resorted to the same techniques of wholesale funding. In my book HRE is more akin to RBS after it bought ABN Amro.
The key information here for me is that the German government can just sort of confiscate shares and investors will be thinking twice before they invest in other German banks if this goes through. Watch German bank share prices carefully as a misstep here could cause a disruption.
Brick,
You make a good point regarding confiscating assets (Christopher Flowers is livid). I wrote about the problem with confiscating banks in November:
http://www.creditwritedowns.com/2008/11/the-problem-with-comprehensive-banking-crisis-solutions.html
John Hempton has been all over this regarding Washington Mutual in the states. It’s also the same reason people are worried about stuffing bondholders, especially senior unsecured.
By the way, I like your RBS comparison. Seems apt.
I’m struck by the comment from an American hedge fund holding shares, which “indicated considerable reservations” about the expropriation law and another piece of legislation approved last month.”
Hedge funds are waking up–or should be waking up–to the reality that they are not, and will never be in the same league a sovereign states like Germany or the United States. Hedge funds (from this layperson’s perspective) were clever regulatory arbitrageurs, but their boom successes went to their heads, especially after drinking too much “free markets” Kool-Aid, and they began really believing that they were “Masters of the Universe.”
Now, the hard reality that regulatory arbitrageurs are parasites on the structure provided by sovereign states — just as banks and markets are non-parasitical but direct beneficiaries dependent on the frameworks provided by sovereigns (including law, regulation, guarantees of contract, and the whole kit and kaboodle) — is hitting home. When a hedge fund or an equity shop negotiates with a business in buying or selling, the fund has a lot of leverage (of both kinds). But when hedge funds find themselves negotiating with states, which can not only bring, or even create, large resources to the discussion, they are already outclassed. But should that not be enough, states have, and have always had, the power to simply change the rules of the game in any way they want. That’s what it means to be a sovereign, after all — something that I think Wall Street and its equivalents forgot.
Every bank that has played chicken with a major state has lost, since Philip II took Spain into its first bankruptcy around 1560. (The states may lose, too, in the longer run, but that’s a different discussion, because such losses did not represent recoveries or gains for the previous banking losers).
The folks trying to game the US Government over Chrysler, just like those who might want to challenge the German government’s decision to nationalise HRE, seem clueless to me, no matter how clever their strategy may look from inside their castles.
So PQuincy, I’m in agreement with the substance and tenor or your remarks. Sovereign governments make the rules, enforce the rules, and can change the rules with great breadth and speed _if they so choose_. Their acts are not without consequences, but some sovereign actors are more consequential than others. Ecuador, Peru; these can be clubbed like seals by large financials. Pakistan, Turkey; these can be done for by financials and other sovereign actors in collusion. States the size of the US or by now Russia can change the gravity well of local reality. Not indefinitely, but then they can also do a great deal to use national resources, funding flows, and the law to sustain and revive economic activity simply by virtue of their size.
This is what is so maddening with regard to watching Uncle Sam in self-bondage to incontinent zombies in Lower Manhattan and the City of London. There is the power to change the rules, which creates the power for a substantially different outcome set, but the present lot of political executives are so system-captured that they don’t see themselves as Gulliver in thrall. We need more expropriation in this country . . . .